Indexed Universal Life
Bobby Samuelson
Bobby Samuelson Founder of Samuelson Design, and presenter to industry groups.
Indexed Universal Life (UL) has been the shining star of the life insurance industry since its resurgence in 2005, clocking double-digit growth figures in spite of a relatively stagnant overall industry environment. With its promise of market-linked upside with principal protection, Indexed UL is a compelling and unique asset class story for cautiously optimistic investors. But Indexed UL has also found favor with promoters of aggressive leveraging strategies. Amidst increasing complexity of both product and application, how do you determine what is sizzle and what is steak? This article flips the normal Indexed UL sales story on its head, starting with a discussion about how a carrier hedges Indexed UL with bonds and options and ending with practical considerations for the sales process.
THE BASICS
Indexed UL is a general account product that offers participation in the performance of an equity index, such as the S&P 500 excluding dividends, with the safety of a guaranteed interest floor. Carriers position Indexed UL between Fixed UL and Variable UL on the risk spectrum, offering some potential long-term upside over Fixed UL without the downside risk of Variable UL. No Indexed UL premium dollars are directly invested in equity indices. Market upside is limited by a nonguaranteed participation rate and/or interest ceiling. Most contracts have a 0 percent to 1 percent guaranteed annual crediting floor. Like crediting rates in Fixed UL contracts, participation limits in Indexed UL contracts may float with economic conditions and carrier discretion.
BENEATH THE GLOSSY PAMPHLET
What differentiates Indexed UL from Fixed UL at the carrier level? Fixed UL offers a near-perfect match of assets and liabilities on a carrier’s balance sheet, linking policy crediting rates to payment streams from fixed income assets. Indexed UL does not offer the same asset-liability match as Fixed UL because equity returns are not directly correlated to general account yields. The carrier would be exposed to loss in a year when equity-based returns promised through participation limits in Indexed UL outstrip general account yields.
Insurance carriers are generally in the business of taking risks they know, primarily mortality and interest rate risk, and avoiding other types. Virtually all carriers with Indexed UL products choose to offload the equity risk inherent in Indexed UL to a third party, typically an investment bank, via derivatives. The carrier’s budget for risk transfer is based on investment yields for the same period over which the risk transfer takes place. High general account yields mean a large hedging budget. The carrier, in effect, transforms the equity risk of Indexed UL to interest rate risk akin to Fixed UL by purchasing hedges. This hedging transaction is at the core of understanding Indexed UL products. Everything about the product that carriers promote in their glossy pamphlets is tied, directly or indirectly, to the cost of transferring risk to a third party.
UPSIDE PARTICIPATION LIMITS
Participation limits on the upside of the product can float at the carrier’s discretion, subject to rock-bottom guaranteed minimums. A hedge to protect the carrier against a high participation limit is more expensive than one to protect against a low participation limit. Because the carrier offloads all of the equity risk, profitability for the hedging trade is determined by how well the cost of the hedge matches up with the general account yield. If the carrier is earning 5 percent on its general account assets, the carrier should set a participation limit that costs approximately 5 percent to fully hedge. Any negative mismatch between the general account yield and the hedging cost means retained risk or direct subsidization of the product. Sustained mismatch typically forces the carrier to change participation limits to maintain profitability.
INDEXED UL ACCOUNT OPTIONS
To cope with increasing competition in the Indexed UL space, carriers have built products with a dizzying array of indexed account options. Agents are often attracted to the sales spin of one particular account, such as a participation rate that is greater than 100 percent. However, the cost to hedge the indexed liability is virtually identical for each account option, indicating that the expected future return for all account options will be, at most, only marginally different. In short, don’t be fooled by a seemingly attractive account option. The math and hedging strategy is largely the same for all of them. Likewise, products with currently stated participation limits above market average are either earning higher yields on their general account assets, taking shortcuts in hedging or packing additional charges into the product to provide funding for the elevated options budget.
ILLUSTRATED RATES
Indexed UL products are commonly illustrated at rates between 200 and 450 basis points above Fixed UL products, making Indexed UL appear to be an exceptionally attractive return proposition for a low interest rate environment. Carriers typically derive illustrated rates by applying currently stated participation limits to historical equity market data. Indexed UL illustrated rates using this method range from approximately 7 percent to 10 percent. All parties admit that this method is fraught with poor assumptions. For example, participation limits would almost certainly have been different in the higher interest rate environment of the 1980s and through the 1990s’ bull market. Perhaps the biggest problem with showing an Indexed UL illustrated rate against a Fixed UL rate is the lack of comparison between Fixed UL crediting rates and hypothetical Indexed UL rates over the same period.
But why should Indexed UL be illustrated at a rate higher than Fixed UL? We’ve already determined that carriers transform equity risk inherent with Indexed UL products to interest rate risk by offloading the equity risk. To a carrier, there’s not much difference between profitability in Fixed UL and fully hedged Indexed UL. Both products offer effective asset liability matching for general account yields. The only instance where an Indexed UL product would outperform its Fixed UL counterpart is by turning a consistent, long-term hedging profit against the investment bank counterpart writing the derivatives the carrier is using to offload risk. The probability of that occurring in the aggregate over a long period of time is most likely very low.
As such, Indexed UL products should be illustrated at a relatively small spread over Fixed UL. I recommend a spread of approximately 50bps to account for relatively large but highly volatile long-term hedging profit. Data released by a large insurance carrier on the actual performance of its inforce block of Indexed UL policies shows, at most, a 50bps spread over Fixed UL. The whole set of data since the year 2000 actually shows Indexed UL underperforming Fixed UL by about 35bps. “Hypothetical Historical” spreads released by carriers are just that—hypothetical. A better basis for illustrations should be long-term expected gains on options or the very limited data that carriers have released about the actual performance of their in-force blocks of Indexed UL.
SALES APPLICATIONS
Accumulation
If Indexed UL were regulated to be illustrated at 25 to 50bps above Fixed UL, would it damage the appealing story of anasset class offering marketing upside potential while retaining principal protection? Absolutely not. Indexed UL is a compelling asset class for accumulation and retirement planning sales even without an illustration showing a rate higher than Fixed UL.
Death Benefit Protection
Indexed UL, as currently priced in the marketplace, is typically not an effective product for low-cost death benefit protection. The average Indexed UL product has substantially higher costs, especially at and beyond life expectancy, than its Fixed UL counterparts. However, Indexed UL products with No-Lapse Guarantee features may provide competitive death benefit-oriented coverage.
Leveraging
Most of the big-ticket sales catching the attention of agents across the country involve premium financed Indexed UL. Marketing groups and carriers are pouring into this space with different flavors of the same claim—financed Indexed UL offers more upside than financed Fixed UL. Some promoters even go so far as to claim that financed Indexed UL is so powerful that the client can pay nothing out of pocket while still retaining large amounts of insurance. Indexed UL is an inherently leveraged product based on its options and bond exposure. Financing Indexed UL adds an additional layer of leverage, creating a huge distribution of outcomes. A few clients will profit immensely from financed Indexed UL, a few will be catastrophically affected, but no one knows the average result. Illustrating Indexed UL at a rate more in line with Fixed UL almost always causes these types of hyper-aggressive financing arrangements to unwind with outstanding liability to the policy owner. Any program that purports to provide a “pay nothing out of pocket” approach based on a single spreadsheet and set of assumptions is showing but one of an infinite number of possibilities. What matters to you and your client are the outcomes that aren’t shown in the sales materials.
The simple story about Indexed UL is that it is an asset class offering a timely mix of upside potential and downside protection. There is little reason to suspect that it will underperform or drastically outperform Fixed UL. Any sales application relying on a sustainable performance spread is likely to come undone with consequences to the policy owner. Instead, position Indexed UL for its story as an asset class rather than its performance
